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Week 3 Capital Asset Pricing Model (CAPM) (Capital Asset Pricing Model…

- - - - Correlation and Variability
        
        Negative Correlation:
        Combined in Portfolio would reduce risk as movement of one will offset by the other
        If assets move independently of each other, then combining them reduces the variability of the return.
        
        Positive Correlation
        Portfolio combination depends on the preference of Risk Return.
      - Beta:
        A measure of systematic risk is β (beta).
        For stock A, with return, RA, the beta, βA, equals the covariance between the return of stock A and the market return, divided by the variance of the market return
        Beta of a Portfolio:
        weighted average of the betas of the individual stocks within the portfolio.
        bp = wAbA + wbbB + wcbC
      - Market Portfolio:
        the most diversified portfolio possible. It includes all stocks available. Due to its diversification, the market portfolio has only systematic risk, and no unsystematic risk.
        The b of the market portfolio is 1 while the b of the risk-free asset is 0.
        The more Stock A is correlated with the market portfolio, the larger its bA. And, therefore, greater is the systematic risk borne by investors in stock A. These investors are compensated by a higher expected return to stock A
      - Expected Return:
        Expected return of stock A is equal to the risk-free rate plus the product of beta multiplied by the risk premium (Expected Market Yield - Risk-Free Rate )
        E(RA) = Rf+ bA*(RM – Rf)
      - Excess Return
        E(RA) – Rf = bA(RM – Rf)
        Suppose the investor utility is linear (increases proportionately with) in excess return and systematic risk.
        Suppose the investor is choosing between stock A, with bA = 1, and stock B, with bB = 2.
        Then, at equilibrium, using the familiar arguments about marginals, we will conclude that as A and B can be *freely substituted for each other, the excess return to B must be twice as much that of A, as the addition of B causes twice as much additional systematic risk.